LECTURE 3: Theory of Demand
Individual Demand
Income and Substitution Effects
Market Demand
Consumer Surplus
Network Externalities
Empirical Estimation of Demand
Cost-of-Living Indexes 생계비 지수
Social security payments are given to qualifying individuals
COLA, Cost-of-Living Adjustment
Each year the benefit increases equal to the rate of increase of the Consumer Price Index (CPI)
Ratio of the present cost of typical bundle of
goods/services in comparison to the cost during a base period
Cost-of-Living Indexes
Does the CPI give a good measure of inflation and therefore a measure of the cost of living changes?
Should the CPI be used to measure how much cost of living has increased determining increases in government payment programs?
Cost-of-Living Indexes
The ideal cost of living index represents the cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base prices
Cost-of-Living Indexes
To obtain the ideal cost of living index would require too much information such as consumer preferences as well as prices and expenditures
Actual price indexes are based on consumer purchases, not preferences
Cost-of-Living Indexes
To obtain the ideal cost of living index would require too much information such as consumer preferences as well as prices and expenditures
Actual price indexes are based on consumer purchases, not preferences
Laspeyres price index and Paasche price index
Laspeyres price index
Amount of money at current year prices that an
individual requires to purchase a bundle of goods and services chosen in a base year divided by the cost of purchasing the same bundle at base-year prices.
Paasche price index
Amount of money at current-year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in a base year.
Cost-of-Living Indexes
The Laspeyres price index assumes that consumers do not alter their consumption patterns as prices change
Tend to overstate the true cost of living index
Using the CPI to adjust retirement benefits will tend to overcompensate most recipients requiring greater government expenditure
Individual Demand 개인수요
Price Changes
Using the figures developed in the previous chapter, the impact of a change in the price of food can be illustrated using indifference curves.
For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves
Individual Demand 개인수요
Price Changes
price-consumption curve 가격-소비곡선
Curve tracing the utility-maximizing combinations of two goods as the price of one changes
individual demand curve
Curve relating the quantity of a good that a single consumer will buy to its price.
Effect of a Price Change
Each price leads to different amounts of food purchased
5
U3 D
4
U2 B
12 20
Assume:
•I = 20 , PC = 2, PF = 2, 1, 0.50
Food (units per month) Clothing
6 A
U1
4 10
Effect of a Price Change
The Price-Consumption Curve traces out the utility maximizing market basket
for each price of food
4
U2 B
12 20 5
U3 D
Food (units per month) Clothing
6 A
U1
4 10
Effect of a Price Change
Demand Curve
Individual Demand relates the
quantity of a good that a consumer will buy to the price of that good.
Food (units per month)
Price of Food
H E
G 2.00
4 12 20 1.00
.50
Demand Curves: Important Properties
The level of utility that can be attained changes as we move along the curve.
At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that
the MRS of food for clothing equals the ratio of the prices of food and clothing.
Individual Demand:
소득-수요 곡선 Income Changes
Using the figures developed in the previous chapter, the impact of a change in the income can be illustrated
using indifference curves.
Changing income, with prices fixed, causes consumer to change their market baskets.
The income-consumption curve 소득-수요 곡선
traces out the utility-maximizing combinations of food and clothing associated with every income level.
Effects of Income Changes
Food (units per month) Clothing
(units per month)
An increase in income, with the prices fixed, causes consumers to alter
their choice of market basket.
3
4
A U1
5
10
B U2
7 D
16
U3
Assume: Pf = 1, Pc = 2 I = 10, 20, 30
Individual Demand
Income Changes
An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve.
Simultaneously, the increase in income shifts the demand curve to the right.
Effects of Income Changes
Food (units per month) Clothing
(units per month)
The Income Consumption Curve traces out the utility maximizing market basket for each income level
3
4
A U1
5
10
B U2
7 D
16
U3
Income Consumption Curve
Effects of Income Changes
Food (units per month) Price
of food
An increase in income, from 10 to 20 to 30, with the prices fixed, shifts the consumer’s demand curve to the right as well.
1.00
4
D1
E
10
D2
G
16
D3
H
Normal Goods 정상재 versus Inferior Goods 열등재
When the income-consumption curve has a positive slope: The good is a normal good 정상재.
The quantity demanded increases with income.
The income elasticity of demand is positive.
When the income-consumption curve has a negative slope: The good is an inferior good 열등재.
The quantity demanded decreases with income.
The income elasticity of demand is negative.
An Inferior Good
Hamburger
(units per month) Steak
(units per month)
30
U3 C
Income-Consumption Curve
…but hamburger becomes an inferior good when the income
consumption curve bends backward between B and C.
5 10
A
U1
5
20 10
B
U2
Both hamburger and steak behave as a normal good, between A and B...
Individual Demand
Engel Curves 엔겔 곡선
Engel curves relate the quantity of good consumed to income.
If the good is a normal good, the Engel curve is upward sloping.
If the good is an inferior good, the Engel curve is downward sloping.
Engel Curves
Food (units per month)
30
10
Income ( per month)
20
4 8 12 16
Engel curves slope upward for normal goods.
Chapter 4 24
Engel Curves
Engel curves are backward bending for inferior goods.
Inferior
Normal
Food (units per month)
30
10
Income ( per month)
20
4 8 12 16
Substitutes 대체재 & Complements 보완재
Two goods are considered substitutes if an increase (decrease) in the price of one leads to an increase (decrease) in the quantity demanded of the other.
Ex: movie tickets and video rentals
Two goods are considered complements if an
increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other.
Ex: gasoline and motor oil
Substitutes & Complements
Two goods are independent then a change in the price of one good has no effect on the quantity demanded of the other
Ex: chicken and airplane tickets
If the price consumption curve is downward-sloping, the two goods are considered substitutes.
If the price consumption curve is upward-sloping, the two goods are considered complements.
They could be both Substitutes & Complements.
Income and Substitution Effects
A change in the price of a good has two effects:
Substitution Effect 대체효과
Income Effect 소득효과
Substitution Effect
Relative price of a good changes when price changes
Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is relatively more expensive.
Income and Substitution Effects
Income Effect
Consumers experience an increase in real purchasing power when the price of one good falls.
Substitution Effect
The substitution effect is the change in an item’s
consumption associated with a change in the price of the item, with the level of utility held constant.
When the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good.
Income and Substitution Effects
Income Effect
The income effect is the change in an item’s consumption brought about by the increase in purchasing power,
with the price of the item held constant.
When a person’s income increases, the quantity
demanded for the product may increase or decrease.
Even with inferior goods, the income effect is rarely large enough to outweigh the substitution effect.
Income and Substitution Effects: Normal Good
Food (units per month) O
Clothing (units per
month) R
F1 S
C1 A
U1
The income effect, EF2, ( from D to B) keeps relative prices constant but
increases purchasing power.
Income Effect
C2
F2 T
U2
B
When the price of food falls,
consumption increases by F1F2 as the consumer moves from A to B.
Total Effect E
Substitution Effect
D
The substitution effect,F1E,
(from point A to D), changes the relative prices but keeps real income (satisfaction) constant.
Food (units per month) O
R
Clothing (units per month)
F1 S F2 T
A
U1
E
Substitution Effect
D
Total Effect
Since food is an inferior good, the income effect is negative. However, the substitution effect
is larger than the income effect.
B
Income Effect
U2
Income and Substitution
Effects: Inferior Good
Income and Substitution Effects
A Special Case--The Giffen Good
The income effect may theoretically be large enough to cause the demand curve for a good to slope upward.
This rarely occurs and is of little practical interest.
Market Demand
Market Demand Curves
A curve that relates the quantity of a good that all consumers in a market buy to the price of that good.
The sum of all the individual demand curves in the market
Summing to Obtain a
Market Demand Curve 시장수요곡선
Quantity
1 2 3 4 Price
0
5
5 10 15 20 25 30
DB DC
Market Demand
DA
The market demand curve is obtained by summing the consumer’s
demand curves
Market Demand
From this analysis one can see two important points
The market demand will shift to the right as more consumers enter the market.
Factors that influence the demands of many consumers will also affect the market demand.
Aggregation is important to be able to discuss demand for different groups
Households with children
Consumers aged 20 – 30, etc.
Market Demand
Price Elasticity of Demand
Measures the percentage change in the quantity demanded resulting from a percent change in price.
Q P P
Q P/P
Q/Q P
%
Q E
P%
Price Elasticity of Demand
Inelastic Demand
Ep is less than 1 in absolute value
Quantity demanded is relative unresponsive to a change in price
%Q < %P
Total expenditure (P*Q) increases when price increases
Price Elasticity of Demand
Elastic Demand
Ep is greater than than 1 in absolute value
Quantity demanded is relative responsive to a change in price
%Q > %P
Total expenditure (P*Q) decreases when price increases
Price Elasticity of Demand
Isoelastic Demand
When price elasticity of demand is constant along the entire demand curve
Demand curve is bowed inward (not linear)
The Aggregate Demand For Wheat
The demand for U.S. wheat is comprised of two components
Domestic demand
Export demand
Total demand for wheat can be obtained by aggregating these two demands
The Aggregate Demand For Wheat
The domestic demand for wheat is given by the equation:
QDD = 1465 - 88P
The export demand for wheat is given by the equation:
QDE = 1344 - 138P
The Aggregate Demand For Wheat
Domestic demand is relatively price inelastic (Ed = - 0.2)
Export demand is more price elastic (Ed = -0.4).
Poorer countries that import US wheat turn to other grains and food if wheat prices increase
C
D
Export Demand
Total world demand is the horizontal sum of the domestic demand AB and
export demand CD.
F
Total Demand
A
B
Domestic Demand
E
The Aggregate Demand For Wheat
Wheat
Price
0
10 16 18
Above C, export demand is zero so domestic demand = total demand = AE segment
Consumer Surplus 소비자 잉여
Consumer Surplus 소비자 잉여
The difference between the maximum amount a
consumer is willing to pay for a good and the amount actually paid.
Can calculate consumer surplus from the demand curve
Consumers buy goods because it makes them better off
Consumer Surplus measures how much better off they are
Consumer Surplus - Example
Student wants to buy concert tickets
Demand curve tells us willingness to pay for each concert ticket
1st ticket worth 20 but price is 14 so student generates 6 worth of surplus
Can measure this for each ticket
Total surplus is addition of surplus for each ticket purchased
The consumer surplus of purchasing 6 concert tickets is the sum of the
surplus derived from each one individually.
Consumer Surplus
6 + 5 + 4 + 3 + 2 + 1 = 21
Consumer Surplus - Example
Rock Concert Tickets Price
( per ticket)
2 3 4 5 6
13
0 1
14 15 16 17 18 19 20
Market Price
Will not buy more than 7 because surplus is negative
Chapter 4 47
Demand Curve Consumer
Surplus
Consumer Surplus for the Market Demand
Consumer Surplus
Rock Concert Tickets Price
( per ticket)
2 3 4 5 6
13
0 1
Actual Expenditure
14 15 16 17 18 19 20
Market Price
CS = ½ ( 20 - 14)*(1600) = 19,500
Network Externalities 망(그물)외부성
Up to this point we have assumed that people’s demands for a good are independent of one another.
For some goods, one person’s demand also depends on the demands of other people
If this is the case, a network externality exists.
Network externalities can be positive or negative.
Network Externalities
A positive network externality 편승 또는 동승효과 exists if the quantity of a good demanded by a consumer
increases in response to an increase in purchases by other consumers.
Negative network externalities (The Snob Effect) 속물효과 are just the opposite.
Network Externalities
The Bandwagon Effect
This is the desire to be in style, to have a good because almost everyone else has it, or to indulge in a fad.
This is the major objective of marketing and advertising campaigns (e.g. toys, clothing).
Positive network externality in which a consumer wishes to possess a good in part because others do
Positive Network Externality:
Bandwagon Effect
동승효과Quantity
(thousands per month)
Price
( per unit)
D20
20
When consumers believe more people have purchased the
product, the demand curve shifts further to the the right .
40 D40
60 D60
80 D80
100 D100
52
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
( per unit)
D20
20
The market demand curve is found by joining the points on the individual demand curves. It is relatively more elastic.
40 D40
60 D60
80 D80
100 D100
Demand
53
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
( per unit)
D20
20
Suppose the price falls from 30 to 20. If there were no bandwagon effect, quantity demanded would only increase to 48,000
40 D40
60 D60
80 D80
100 D100
Demand
But as more people buy the good, it becomes
stylish to own it and the quantity demanded
increases further.
30
48 20
Pure Price Effect
Bandwagon Effect
Network Externalities 속물효과
The Snob Effect 속물효과
If the network externality is negative, a snob effect exists.
The snob effect refers to the desire to own exclusive or unique goods.
The quantity demanded of a “snob” good is higher the fewer the people who own it.
Network Externality: Snob Effect
Quantity (thousands per month)
Price
( per unit)
2
Demand
D2
30,000
15,000
14
Originally demand is D2, when consumers think 2000 people have bought a good.
4 6 8
D4
D6 D8
However, if consumers think 4,000 people have bought the good, demand shifts from D2 to D6 and its
snob value has been reduced.
Pure Price Effect
Chapter 4 56
Network Externality: Snob Effect
Quantity (thousands per month)
Price
( per unit)
2
Demand
D2
30,000
15,000
14 4 6 8
D4
D6 D8
Pure Price Effect
The demand is less elastic and as a snob good its value is greatly
reduced if more people own it. Sales decrease as a result.
Examples: Rolex watches and long lines at the ski lift.
Net Effect
Snob Effect
Empirical Estimation of Demand
The most direct way to obtain information about demand is through interviews where consumers are asked how much of a product they would be willing to buy at a given price.
Problem
Consumers may lack information or interest, or be mislead by the interviewer.
In direct marketing experiments, actual sales offers are posed to potential customers and the responses of customers are observed.
Empirical Estimation of Demand
The Statistical Approach to Demand Estimation
Properly applied, the statistical approach to demand estimation can enable one to sort out the effects of variables on the quantity demanded of a product.
“Least-squares” regression is one approach.
Assuming only price determines demand:
Q = a - bP
Q = 28.2 -1.00P
Estimating Demand
Quantity
Price
0 5 10 15 20 25
15
10
5 25
20
d1
d2
d3 D
D represents demand if only P determines demand and then from the data: Q=28.2-1.00P
Estimating Demand – Changes in Income
Quantity
Price
0 5 10 15 20 25
15
10
5 25
20
D d1
d2
d3
d1, d2, d3 represent the demand for
each income level. Including income in the demand equation: Q = a - bP + cI or Q = 8.08 - .49P + .81I
